Investors: Yes, You DO Need an Ample Amount of Reserves. Here’s Why.

Remember Supermarket Sweep? For those who pre/post-date the show, here’s a refresher:

Supermarket Sweep is an American television game show. The format combined an ordinary team-based quiz show with the novel concept of a live, timed race through a supermarket. In the timed race, cameras followed the teams with shopping carts through a large vacated supermarket with several aisles; the value of items thrown into the cart determined the winning team. (Wikipedia)

The best contestants load up their carts with high-value, low-volume items. Think filet mignon, organic spices, aged cheese, and olives. The goal is to find value in small packages, thereby maintaining maximum remaining shopping cart capacity.

Real estate investors are running around with a cart full of properties, partnerships, loans, service contracts, or some other strategy’s execution. Whatever your game, there is a sweep phase where you go out and shove items into your cart.

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The Problem

When the Supermarket Sweep winners return home, they still have to cook dinner. Additionally, they have to make the ingredients last a week or so. All while providing an enjoyable meal for their families.

Another factor is preservation, like ensuring that the leftover ingredients don’t go bad. Also, there are some tradeoffs. They may have loaded their carts with olives, but they actually don’t like them much.

For my part, I think they’re crazy because I love olives! I do understand this feeling in the context of real estate. The dust settles, the excitement wanes, the contracts are signed, the tenants move in, and you continue to exist.

The problem is that we’re encouraged and motivated to close the deal, but we don’t hear a lot about what to do for the remaining decade and onward. We know that we’re becoming landlords, but we’re not sure what that means on a day to day basis.

Enter Reserves

Understanding this “problem” has been our year. We are in a quieter phase and have not closed a single deal in 2016. The main reason is that our refrigerator is full. We are solidifying our operations: systematically, legally, and financially. Some of you know that I balance equally between real estate and public market investing. In 2015, our real estate holdings outpaced our market portfolio. Given that, we are in a season of rebuilding on the market side.

The one thing I have learned not to underestimate is our constant need for reserves. I can’t tell you how many times our ability to write a check and expedite a process has solved our problems. My wife and I can do this because of our W2 incomes. Although we make mistakes, they’re not tragic or foreclosure-worthy because we can handle them with grace.

It’s important to note that we’re not just dumping money into properties in hopes of a future break-even appreciation moment. On the contrary, we’re very aware of how much each property is costing us, and we still have one that is thoroughly in the red. Every year, our continuing costs will play into how we evaluate exit timelines and continuing value-adds.

The problem is we would be more out of luck if we didn’t have the reserves available. On top of that, we would stunt our growth and education. Doing things the right way costs money, and there’s not an easy button for most of it. Here’s a laundry list of things that have come up:

Capital Expenditures

Also referred to in the shorthand as “cap ex,” this is truly the iceberg under the water. This year has been a big year for clogged and one exploded sewer pipe (separate properties, separate states). The reality is these things hurt, and they’re rarely noticed when they’re working fine.

We also had some issues with siding and other little cosmetic notes. All this adds up to a variety of reserves going out the door at the time you least want it. Expenses and income never seem to arrive at the same time. Make sure you’re covered.

LLC Formations

We’re very serious about the business and legal side of real estate. I think we’re even more cautious because we actually have an entire estate and other assets to raid in the case of a legal battle. Most importantly, we’re developing and scaling systems. All the professionals pay lawyers, so we must do the same. Like any good legal cost, this one comes up front and is another notable drag on reserves.

CPA

Certified public accountants are as good as they are costly. The best part is that the tax laws differ from state to state, so sometimes we get to pay more than one. The best I can say is that the good ones are looking for repeat business and will try not to take you to the cleaners. Just remember, it happens every year.

Account Minimum Balance

Keeping a minimum balance certainly costs money. This shouldn’t be a huge issue after a year or so because you should be keeping maintenance funds for your properties (see cap ex above). However, when you first open the account, this could be high dollar, particularly for SFH properties that tend to generate something like $3-5k a year. Our business accounts require a minimum balance of $2k.

Evictions

We did our first one this year. My impression was that it actually went pretty great. Despite that, there are always costs. We had a couple small fees for the court (thank God, no lawyers). We also had to pay a cleanup crew to get the apartment in shape. This is the consequence of out-of-state, passive investing. Even when you’re local, if your time has value, it’s a price everyone has to pay for an eviction.

Gifts for Our Team

OK, definitely a small and worthwhile one, but it’s something. I want our managers and their admin people to be happiest when talking to (and working for) us. One of the best ways to get to the top of their pile is a small sign of appreciation. Very few people do this, and that is the reason it is worth doing.

Continuing Travel Budget

This is more specific to out-of-state investors. Sometimes you need to travel to your properties. Sometimes face-to-face is the best kind of encounter. Sometimes the potential cost of labor is too high, and you’re the one to take a long weekend to do it. Reserves, reserves, more reserves.

If you’ve concluded this article thinking that real estate is a giant money pit, then you may not be far from wrong. In all seriousness, I think it’s a great investment vehicle. Like anything profitable, you get paid for dealing with nonsense. Nonsense tends to arrive several days before your next check or wire transfer.

Make no mistake, when you buy real estate, you are buying a huge, expense ridden, taxable asset. Your goal is to run faster than the expenses and plan for your own sanity. In the interest of your brain, keep some reserves on hand.

Investors: Any other expenses you’d add to this list? When’s a time when you found you needed to use your reserves?

Let me know with a comment!

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About Author

Trevor is a partner and software engineer with Neosavvy, a New York consultancy. Trevor is a landlord and value investor focused on long-term, buy and hold through partnerships. Trevor writes about passive investing, real estate, and personal finance at pearoftheweek.com.

13 Comments

Trevor, I don’t know if you know how RIGHT you are. Just to give an example, THIS WEEK, we received the estimates for a property that went vacant July 1. The property rented for $750 a month and my cleanup/repair estimate is $10,000.00. My records show that we spent $4,000.00 on repairs on this rental in 2015. Why ten grand? The tenants ripped all the interior doors off the hinges, tore the bathroom vanities off the walls, punched holes in the drywall, ripped all the baseboards off, broke out some Windows, etc… We are replacing the carpet with vinyl. Luckily we have reserves to cover it. These things do happen and if you are not prepared and don’t have any resources, it can make it nearly impossible to get the house rented again.

It’s truly insane what tenants can accomplish, and I am sorry for the annoyance and the financial hardship this has caused.

The last property we bought had several thousand dollars of plumbing issues when we first got it. As a thought experiment, I asked myself, what else could I possibly do? The answer is nothing, short of selling it at a huge loss. Nobody wants to buy an immediate and obvious repair job. The reserves were the only thing that kept it from sitting vacant. Get it up, get it running, and keep moving.

We already have it rented at $950, they are just waiting for repairs to be done. As a side note, it is a good idea to keep a spreadsheet of when certain items are done so you can get an idea of how often certain expenses come up.

Thanks for this share Mike & Trevor!
I always wonder about folks who say “Oh, just take out a larger loan/borrow if you can’t afford closing costs / non-PMI-requiring down payment.” My thoughts: If I can’t afford closing costs and the down, perhaps I should be waiting, until I have more cash in the bank.
The good old time-consuming way… Through work.

You’re not a real estate investor unless you’re at least a little cash poor (at least for a long while at the beginning). But you’re absolutely right, you need to keep reserves for a rainy day and all the other problems that can come up.

I think you’ve confused investor with high risk speculation. It works out for many as the reach a point with reserves as the market trends in their favor. Buy many down markets are filled the the fall of those with the same approach.
House of cards for some.

Andrew, I agree that there is a certain level of scrappiness and risk that all investors definitely take. And it works for the first few anyway, when we’re all just one private loan away from a solution. Larger portfolios are less forgiving, and I don’t have to be the one to tell you that. Thanks for reading!

It’s really tough. The tenant got on a payment plan with us, but I am not holding my breath. I have not seen anything and don’t expect to. We took a risk with a tenant who looked terrible on paper. I don’t question our intentions, but it’s a shame when the likely thing happens, even when you’re trying to give someone a chance.

Money management was the tenant’s problem to begin with. I doubt debt management would be his forte. For my part, I could go after him, but I would spend more time and money on it. In the end, I would have an angered person (who did not mess up the place on the way out, I may add), and less money.

Great question. We hold back 10% of the NOI (and expected NOI). In other words, we put our own money if the unit is vacant. This gives us a slight buffer for when the really big stuff comes down the pipe. I do think this has to be case by case, but a couple notes about how we arrived at this number:

– 10% is simple
– All of our properties are recently rehabbed, and therefore have a few years for accumulation on the bigger CapEx.
– With our W2 jobs and side work, we can easily cover the difference if something goes over. This is not a situation where we would be massively out of luck if something really bad happened.

In the last case, I will note that you should treat this like a loan to the LLC, and not just wipe your hands and assume you’re still profitable. Until that balance is paid again, you will not turn a profit.